Crystallization is the process by which profit or loss from an asset is realized upon the sale of the asset. The mere purchase of an asset or security does not translate to a profit or loss, even if the asset increases or declines in value.
The crystallization of securities triggers tax implications for the investor that vary depending on whether the investor recognizes a capital gain, capital loss, or both. Learn about the investment crystallization process, how crystallized assets are taxed, and some of the pitfalls an investor might encounter in the process.
Definition and Examples of Crystallization
Investors do not recognize a gain or loss upon the purchase of a security—or even if the security rises or falls in value while in the investor’s possession. Gain and loss are only recognized upon the sale of the asset, at which point the gains or losses are crystallized, or realized.
For example, an investor bought 100 shares of Company A stock and 100 shares of Company B stock at $20 per share.
If they sold their Company A shares three years later for $40 a share, the investor crystallized a capital gain of $2,000:
Capital gain from sale of Company A shares = ($40-$20) x 100 = $2,000.
Conversely, should the same investor sell their 100 shares of Company B for $10 each, they will have crystallized a capital loss of $1,000:
Capital loss from sale of Company B shares = ($20-$10) x 100 = $1,000.
How Crystallization Works
When investments are held, the changes in their value affect the investor's net worth, but not their tax liability. The investor’s potential tax liability only kicks in when the asset is liquidated. At this point, the gain or loss on the investment is realized or crystallized.
Investors are required to pay a capital gains tax upon earning a profit from the sale of a security.
The capital gains tax liability is dependent on a number of factors, such as the duration the investment was held for, the investor’s income tax bracket, and even the type of asset.
Investments held over a year and then sold for a gain attract a long-term capital gains tax. Based on your income, you could pay nothing or up to 20% as long-term capital gains tax.
Capital gains from selling an asset held for less than a year would attract a short-term capital gains tax, which is typically taxed at ordinary income tax rates.
Let’s assume our investor has an annual income of $80,000. As he held the shares of Company A for three years, any capital gains he made from that sale would attract a long-term capital gains tax. Based on their income, the IRS pegs their long-term capital gains tax rate at 15% and the tax liability will amount to $300:
Long-term capital gains tax from sale of Company A shares = $2,000 x 0.15 = $300.
That said, the investor can offset the tax liability by also crystallizing a concurrent capital gains loss. Expanding on our example further, if our investor were to recognize his $1,000 loss on their Company B investment, net capital gains will amount to $1,000:
Net capital gains from sale of Company A and Company B shares = $2,000 + (- $1,000) = $1,000.
The investor’s tax liability will then only amount to $150:
Net capital gains tax liability = $1,000 x 0.15 = $150.
What Crystallization Means for Individual Investors
Crystallization helps put a number to the capital gains or loss an investor incurs when they sell or liquidate an investment. That is invaluable information, especially for tax purposes.
Some investors may try to offset their capital gain tax liability by selling their securities at a loss in order to crystallize the capital loss and then immediately repurchasing the security under the assumption that the investment will later appreciate in value. This strategy is known as a wash sale, and it is restricted by the U.S. government.
The IRS does not allow you to deduct capital losses for securities for which you have capital gains from another transaction 30 days before or after you trade it at a loss.
The IRS has limits on how much capital loss deduction you can claim, so investors may only reduce their ordinary income by $3,000 per year ($1,500 if married filing separately).
That said, crystallized losses may be carried forward indefinitely until the loss amount is used up and offset against future capital gains in order to minimize your tax liability.
Coming back to our investor who sold their shares in Company A for a capital gain of $2,000. Now suppose they crystallized $15,000 in capital losses for the year (including the loss from the sale of Company B). That means they have a net capital loss for the year.
Overall net capital loss= $2,000 + (-$15,000) = $13,000
This net capital loss has effectively offset the $2,000 capital gain and eliminated the investor’s capital gains tax liability for the year.
The investor can further reduce ordinary income by $3,000, leaving over $10,000 of unused capital losses to be carried forward. They may use this remaining $10,000 capital loss in subsequent years to offset future capital gains and/or reduce ordinary income.
- Crystallization refers to the recognition of profit or loss upon the sale of an investment.
- Crystallized investment profits are subject to a capital gains tax, which can be offset by capital losses.
- The IRS restricts wash sales, which are crystallization strategies wherein investors sell their stock at a loss and then immediately buy them back in order to eliminate their tax burden.
- Capital losses can be carried forward for a $3,000 maximum annual ordinary income reduction until the unused loss amount is used up.